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Tuesday, December 19, 2017

How Banks REALLY Create Money

Last Thursday we
looked at Dr. Harold Moulton’s statement about the two functions of a
commercial bank, or — more specifically — how such a bank makes loans . . .
which is how commercial banks create money, regardless what the Keynesians
tried to tell you in all those textbooks.

Money doesn't have to be coin or bills (although that helps).

As a reminder, “money”
is anything that can be accepted in settlement of a debt: “all things
transferred in commerce.”It all comes
from Adam Smith’s first principle of economics: “Consumption is the sole end
and purpose of all production.”

Not counting
charity, gift, theft, or inheritance (we think that covers everything), there
is only one way to be able to consume, and that is to produce.(The other ways enable someone to consume
without producing.)

Consequently, you must either produce for your
own consumption, or to trade to others for what they have produced that you
want to consume.“Money” is what we call
the contract between two or more people exchanging things of value that have
been produced and, presumably, are meant for consumption.

As you can see, “money”
can take any form convenient to the parties to a transaction.It doesn’t have to be some kind of official
certificate as long as both parties are satisfied.

Standards are helpful when more people come in.

The problem comes
in when a transaction goes beyond parties who know and trust each other.You need some generally recognized form of
money that people can trust, even if they are completely unacquainted with the
original parties to a transaction.

That is where a commercial
bank comes in.A commercial bank is in
the business of creating general promises (“money”) that people in the
community will recognize out of individual promises made by borrowers from the
bank.

And how does a
bank do that?By making loans.But doesn’t making loans increase the money
supply by depositing the proceeds, and then loaning them out again?

No.All that happens is that the original amount
of new money gets passed around from hand to hand.No new money can be created by making
deposits, only by making loans.According
to Harold Moulton,

Dr. Harold G. Moulton

Let us assume that business men, in response to this
invitation, come to the bank for loans with which to conduct their business
operations. Mr. A is given a loan of
$100,000 for four months, the interest at 6 percent being deducted in advance.
He has the option of withdrawing $98,000 in actual cash from the bank or of
having it credited as a deposit account against which he may draw checks. Since
drawing checks is a safer and more convenient means of making payments, A elects to take a deposit account covering
the entire $98,000. Inasmuch as we wish to focus attention upon this particular
transaction, we shall omit from the balance sheet the $100,000 of new deposits
which we assumed had been made in the form of cash. The balance sheet would
then stand as follows:

Suppose now that Mr. A writes a check for $98.000 in favor of Mr. B. Suppose also that B desires
to be a customer of this bank, and upon receipt of the check presents it at the
bank and asks that an account be opened in his name and that the $98,000 check
be deposited to this account. It is evident that the result of this operation,
so far as deposits are concerned, is merely to deduct $98,000 from A's account and add $98,000 to B's account. The total deposits owed by
the bank remain unchanged. While B's deposit
account comes over the counter in the form of a check presented to the bank, it
is obvious that it is still indirectly the result of the loan that was made to A.

Since it is more convenient for B to meet his obligations by means of checks rather than in the
form of actual cash, we may assume that he will write checks to those to whom
he is indebted. Let us assume that he writes four checks of $24,500 each; and
that Messrs. C, D, E, and F, desiring to do business with this
bank, in turn present these checks for deposit. The net result still is to
leave the total of deposits unchanged; though instead of being credited to A or B
the deposits are now credited to the accounts of other individuals. In their
turn C, D, E, and F may write
checks against their deposit accounts for varying amounts and to the order of
sundry persons. If all the people receiving such checks in turn present them to
this bank for deposit to their respective accounts, it is obvious that, while
there would be an ever-shifting personnel among depositors, the total deposits
would remain at $98,000.

It is obvious,
then, from this description, that the Keynesian money multiplier simply does
not create money.Money is only created
by making new loans, not by re-depositing existing deposits.